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(Rule-Comments@Sec.Gov) Ms. Vanessa A. Countryman Secretary May 23, 2021Via email ([email protected]) Ms. Vanessa A. Countryman Secretary U.S. Securities and Exchange Commission 100 F Street, NE Washington, DC 20549-1090 Re: File No. S7-25-20; Custody of Digital Asset Securities by Special Purpose Broker-Dealers (Release No. 34-90788) Dear Secretary Countryman: Inca Digital appreciates the opportunity to provide comment on the U.S. Securities and Exchange Commission Statement and Request for Comment regarding "Custody of Digital Asset Securities by Special Purpose Broker-Dealers." I. About Inca Digital Inca Digital’s mission is to provide enterprise grade data collection, infrastructure, and analytics across the digital asset ecosystem to create a more transparent marketplace where investors, companies, government agencies, and other marketplace participants can make objective, data-driven decisions. Inca Digital utilizes a data platform called NTerminal to analyze phenomena occurring in the digital asset space. NTerminal processes financial data––from over five-hundred exchanges such as orders, trades, and third-party reference prices, technical data––stemming from blockchain data, blockchain meta-data, GitHub repositories, and more, and natural language data––arising from news, blogs, social media, messenger channels, the decisions of financial regulators and law enforcement globally, and other natural language sources to detect patterns useful for understanding trends in the digital asset space. In addition, Inca Digital helps clients with compliance issues by monitoring international regulatory filings, active national security directives, disciplinary actions, regulatory decisions, and KYC and AML compliance. Inca Digital also monitors blockchain for irregularities that may point to fraud, money laundering, terrorist financing, and market manipulations like wash trading or pump and dump schemes. Our clients are financial regulators, fund managers, custodians, national security agencies, law enforcement agencies, insurance companies, and infrastructure providers. Several clients worthy of mention are the Department of Defense, Commodities Futures Trading Commission, Ontario Securities Commission, Hehmeyer Trading and Investments, Forbes, Bermuda Monetary Authority, and ErisX. These clients rely on Inca Digital for cutting-edge data solutions to strategically structure their market participation. II. Reply to Request for Comment As a digital asset analytics firm acutely aware of the risks inherent to this industry, we fully support the Commission’s encouragement of broker-dealer’s to operate under the circumstances described in Section IV of the comment request. We would, however, note that while the commission has granted direction with respect to the application SEC's Customer Protection Rule, 17 CFR 240.15c3-3 in the digital asset space, there is little information on how to comply with Custody of Funds or Securities of Clients by Investment Advisers 17 CFR 275.206(4)-2. It is Inca Digital’s opinion that the satisfaction of Section IV should satisfy both the aforementioned regulative requirements. There are several measures custodians would be advised to take to ensure the utmost security of their client's cryptocurrency investment. The methods enumerated below might be a good start to applying, to the cryptocurrency arena, the regulatory intent of the SEC's Customer Protection Rule, 17 CFR 240.15c3-3, and Custody of Funds or Securities of Clients by Investment Advisers 17 CFR 275.206(4)-2. Custodians should implement practices to safeguard the investor's fund at every level and opportunity within the crypto ecosystem. Thus, for custodians to ensure proper protection, (1) it is imperative that the wallet holding cryptocurrency be secure; (2) custodian's cybersecurity team must implement mechanisms to solve the single point of failure problem; (3) the company should have digital asset insurance to compensate cryptocurrency holders in case of loss; and lastly, (4) for transparency, it is necessary for custodians to hire third-party compliance organizations to test for general adherence with procedures to manage the risks inherent to financial technology generally and cryptocurrency specifically. A. Guarding the Crypto Wallet1 Custodians store cryptocurrency in several different types of wallets, differentiated by degrees in temperature. The "temperature" measures the degree of accessibility a client has to their wallet's 1 Allesio Quaglini, Digital Asset Wallets & Signing Algorithms: A Custodian’s Overview,-HEX TRUST, (July 21, 2020), https://medium.com/hex-trust/digital-asset-wallets-signing- algorithms-a- custodians-overview-ea3badee369c. funds, and in turn, the exposure to malevolent hacks. There are four wallet temperatures, (a) cold, (b) hot, (c) warm, and (d) freezing. 1. Cold Wallet Cold Wallets are "air gapped"––placed in a digital storage unit detached from the internet. Because they are disconnected and safe from hackers, they provide a heightened level of security. However, given that they are air gapped, these wallets do not allow quick trading and require anywhere from one to twenty-four hours before a crypto trader may sign off on a transaction.2 Also, another trade-off, because clients and custodians utilize these wallets manually, it becomes difficult to scale such storage facilities without allowing access to multiple people, potentially undermining the very security a firm seeks to implement. One more subtle issue: air-gapped technology is more complicated to upgrade and integrate new protocols because the technicians must implement these changes manually. Long-term investors often use Cold Wallets because they plan to hold their investment for long periods of time and are not looking for the flexibility to trade at a moment's notice. Non-long-term investors also use this sort of wallet if they are storing an enormous amount of crypto and seek increased security measures. 2. Hot Wallet Unlike Cold Wallets, Hot Wallets are attached and accessible via the internet. Therefore, to some degree, this wallet is more vulnerable to hackers. Those who own smaller amounts of crypto and are less likely the targets of a hacker's machinations are more likely to utilize Hot Wallets. Day traders who have more than the average amount of crypto in their account also use this sort of wallet because they need immediate access to buy and sell crypto at a moment's notice. Serious 2 Id. investors usually will have most of their funds in a Cold Wallet but leave some in their Hot Wallet to benefit from the unique features of both mechanisms. 3. Warm Wallet There is no single industry standard or definition for Warm Wallets. Instead, each provider uniquely implements this sort of wallet according to the way they see fit. Some custodians might use this term in reference to a technical setup where they store the crypto in a Cold Wallet, but the wallet is connected to the host computer for the signing process. Others might be referring to Hot Wallets with which the provider has integrated additional layers of security. These measures may include whitelisting––the ability to process transactions only to specific whitelisted addresses and transaction policies––only allowing a predetermined volume and frequency of trades from a particular wallet. Both these measures limit the possibility of hijacked crypto key transactions. 4. Frozen Wallet Some custodians allow their customers to utilize another wallet type, called Frozen Wallet or Deep Cold Wallet. Like Warm Wallets, the term may refer to a multitude of different wallet features. Firms use this term to reference Cold Wallets with added security features. These features may include completely air-gapped environments for private keys and their servers, the geographical distribution of wallets, and sharding of the wallets (splitting one wallet amongst several different databases). Because Warm and Frozen Wallets do not necessarily have a universal custodial meaning, users need to research and understand each custodian's method of wallet implementation. Custodians typically use a combination of hot and cold wallets to manage their customer's funds with the option to upgrade hot and cold to warm and frozen, respectively. Regulatory bodies should consider mandating exchanges to inform the user of the pros and cons of each wallet based on the needs of the consumer. As a prerequisite, crypto custodians will need to fully understand each investor's goals to effectively customize the wallet for their use. After a client deposits crypto with a custodian, the provider typically rebalances the funds between cold and hot wallets, leaving most of the funds––usually more than 90%––in the former for security purposes.3 Because funds in different temperature wallets impact a client's access to crypto and, therefore, the ability to trade, the allocation of assets amongst wallet types significantly impacts market liquidity in each exchange. Thus, although the trader's interest primarily governs the distribution of crypto among wallets, it is crucial from a regulatory perspective to understand the downstream consequences of such a structure on liquidity and the subsequent impact on market price. To incentivize liquidity––to try and keep crypto at a stable price––regulatory bodies might consider prohibiting traders from keeping 100% of their crypto in Cold Wallets. While the advent of businesses and some state and local governments accepting bitcoin as a form of payment may sufficiently curb any liquidity issue for bitcoin, such a move will help stabilize
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